February 01, 2013

Mr. Krugman's Science, part 2

Paul Krugman is enormously proud of the "spectacular success" of Keynesian economics as far as its predictions concerning the aftermath of the Great Recession are concerned.  This spectacular success, which Mr. Krugman rushes on each occasion that he writes about it to share, is based upon certain fundamental tenets of the Holy Writ, the General Theory written by John Maynard Keynes during the Great Depression. 

Essentially, these predictions include:

1.  America is stuck in a "liquidity trap," a financial condition in which the Federal Reserve's control over short-term lending rates is ineffective, even after lowering rates practically to zero (zero interest rate policy, or ZIRP).  This is because everybody is broke and doesn't want to borrow money anyway.

2.  In such conditions of a depressed economy, the government can borrow freely at low rates and can print money with abandon without fear of (a) sparking inflation or (b) inciting the "bond vigilantes" to attack the sovereign debt-issuing function; that is, to cause an increase in the borrowing costs of the federal government.

3.  During such depressed times, it is a mistake for the government to engage in austerity; rather, this is the time for the federal government to step in and spend money so as to boost overall demand, which lags because of the broke-ass situation of the American Consumer (Homo consumeris, formerly known as "citizens").

Mr. Krugman has been proven right about everything (not to mention the work of the Great One whose theory he champions), and Mr. Krugman's many detractors and political opponents have been proven wrong.  While others, such as the misguided Bowles-Simpson Committee and the whole of the Republican Party, have urged fiscal restraint on budget cutting, Mr. Krugman believes that the $1 trillion budget deficits we are currently running, which force the government to borrow about 40% of everything it spends, are "too small."  He does not precisely quantify how far off we are in our deficits; we should go deeper in the hole, but Mr. Krugman does not offer precise guidance on how far down.

One must admit that the principles outlined above make some intuitive sense.  The federal government can issue the benchmark ten-year bond at a coupon rate of around 2%, below the rate of inflation; thus, in a way the money the Treasury borrows is essentially free, and can be added to the pile of existing public debt (currently around $11 trillion) while not greatly straining the federal budget's allocation to debt service.  Further, and although this is not a point that Mr. Krugman emphasizes, the Federal Reserve Bank itself actively participates in the Treasury bond market.  This is putting the matter rather modestly, in fact: under the current iteration of Quantitative Easing, the Fed will buy approximately 1/2 trillion more in bonds to add to its existing stash of about $1.4 trillion. Indeed, the Federal Reserve is the largest single holder of U.S. public debt in the world, and will leave the field in the dust over the next 12 months, as its holdings approach $2 trillion.

The Federal Reserve is not permitted, by law, to purchase Treasuries directly at auction.  This would "distort" the market, of course, since one buyer which can print its own money and doesn't care what the return is, would exercise an unfair advantage over other buyers.  However, this is probably a distinction without much difference, because the Fed's purchases on the secondary market are from the Primary Dealers, its own Klaque of Kool Kids who "make the market" in Treasuries at auctions and usually take down about half the issuance.  Since the Primary Dealers know that the Treasuries they purchase can be flipped to the Fed, they are similarly sanguine about their participation; that is, they can keep 'em if they want 'em, but if they don't, Uncle Ben will take them off their hands.

The Federal Reserve operates, thusly, as a sinkhole for U.S. Treasury debt: while the Fed is "credited" with interest payments from the Treasury, in reality this credit is remitted right back to the government, and thus the Treasury makes money on its own debt.  To make this wonderful situation even more perfect, the Fed simply conjured up the money to purchase its Treasuries out of thin air. Thus, the federal government is making money on its debt with money hallucinated out of nothing.

A mind more suspicious than mine or Mr. Krugman's - perhaps your mind, come to think of it - would perhaps at this juncture start wondering whether the interest rate situation, and the failure of the bond vigilantes to appear, might have more to do with this merry-go-round than what you might call "market fundamentals." That is, we're simply buying our own debt with money we create out of thin air.  That's the short form of the situation.  Other purchasers of federal debt, such as the Chinese government, buy Treasuries not so much for yield (which is nonexistent after taking into account inflation) but for currency stabilization purposes.  The Chinese buy Treasuries to boost the value of the dollar against the yuan for trade purposes, and to have some place to stash all those U.S. dollars they receive as the result of shipping stuff to the United States.

As I say, this is not something which Mr. Krugman spends a lot of time on, but it certainly seems worth thinking about as an alternative explanation to that expounded by the great John Maynard Keynes.

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